Monetary Policy

  • September 26, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
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Monetary Policy

Subject: Economy

Context

The RBI is supposed to be accountable, but it can’t win the inflation battle without the government given the Food and beverage items have a combined 45.86% weight in the overall CPI.

Details:

Under section 45ZA of the RBI Act, 1934, MPC has fixed the CPI inflation target at 4% with an “upper tolerance limit” of 6%.

  • Under the new statutory framework, the central government would, in consultation with the Reserve Bank of India (RBI), set an inflation target based on the consumer price index (CPI) once every five years.
  • The RBI was entrusted with the responsibility of meeting this target –”accountability” and RBI has been given “independence” in the conduct of monetary policy for this.

What is the failure of monetary policy?

  • A breach of the “tolerance level” for three consecutive quarters will constitute a failure of monetary policy.
  • In case of monetary policy failure-the RBI, under section 45ZN of the RBI Act it will send a report to the central government stating:
    • reasons for the breach/failure of monetary policy
    • propose remedial actions to bring it down to 4 per cent, and
    • provide an estimate of the time-period within which the target would be achieved.
  • These would be presented in a report to the Union Ministry of Finance.
  • It would be up to the government to make the RBI report public.
  • The special meeting of the MPC will discuss the RBI report before it is submitted.

Limits of monetary policy to control inflation:

  • When the inflation is cost-push type
    • In the case of cost-push inflation, the control measures revolve around increasing the supply to meet the demand in the market and reducing the prices by providing subsidies and technological expertise.
    • RBI has to depend on supply-side measures by the government rather than curbing demand by monetary policy tools.
  • The Monetary fiscal conflict:
    • Government interference to set lower interest rates (to achieve higher growth)    conflicts with inflation targeting (which involves increasing rate of interest).

Measures to curb cost-push inflation:

These measures mainly aimed at increasing the supply of goods in domestic market and reducing the cost of production taken especially by the Government:

  • Import duty on exportables
  • Banning exports
  • Stock declaration by traders and manufacturers- to prevent hoarding
  • Strict action against hoarding & black marketing
    • Effectively enforce the Essential Commodities Act, 1955 & the Prevention of Black-marketing and Maintenance of Supplies of Essential Commodities Act, 1980
  • Higher MSP to incentivize production and thereby enhance availability of food items which may help moderate prices.
Tools of inflation targeting used by the RBI:

Quantitative measures:

  • Statutory Liquidity ratio (SLR)   
    • To combat inflation, the RBI must raise the SLR. When the SLR is raised, banks are required to keep a larger amount in safe and liquid assets. As a result, the bank’s ability to lend to the market declines, lending rates rise. Market liquidity will shrink, as a result, inflation is controlled.
    • The RBI must decrease SLR to fight deflation, which works the opposite way.
  • Cash Reserve Ratio (CRR)
    • To combat inflation, the RBI must raise the CRR. When the CRR is raised, banks are required to keep a larger amount of cash with the RBI. As a result, the bank’s ability to lend to the market declines, lending rates rise. Market liquidity will shrink, as a result, inflation is controlled.
  • Repo Rate   
    • During periods of high inflation, the RBI raises the repo rate to reduce the flow of money in the economy. A rise in the repo rate disincentivizes banks from borrowing from the RBI. As a result, market liquidity decreases. Lending rates rise, making borrowing more expensive for businesses and industries, slowing investment and money supply in the market. It aids in the control of inflation.
  • Reverse Repo rate
    • To combat high levels of inflation, the RBI raises the reverse repo rate. It encourages banks to park funds with the RBI (more certainty of return + higher interest rate) rather than lend to the private sector. As a result, market liquidity is reduced and borrowing interest rates rise. Borrowing will be more expensive for private players, reducing investment. It aids in the control of inflation.
  • Bank Rate    
    • During periods of high inflation, the RBI raises the bank rate to reduce the flow of money in the economy. A rise in the bank rate disincentivizes banks from borrowing from the RBI. As a result, market liquidity decreases. Lending rates rise, making borrowing more expensive for businesses and industries, slowing investment and money supply in the market. It aids in the control of inflation.
  • Marginal Standing Facility (MSF)         
    • The MSF which is aligned with the bank rate will be increased by the RBI to reduce the flow of money supply and disincentivize people and firms to borrow. This will help control inflation.
  • Open Market Operation (OMO)           
    • To combat higher levels of inflation, the RBI drains the market of excess liquidity by selling government securities. Banks lend money to the RBI by borrowing government securities. This reduces the economy’s excess liquidity. Lending rates rise, making borrowing more expensive, stifling private investment. As a result, it prevents inflation.
  • Market Stabilisation Scheme (MSS)    
    • To combat inflation, the RBI, in a manner similar to the Open Market Operations, sucks out excess liquidity in the economy by selling government securities. Banks lend money to the RBI by borrowing government securities. This reduces the economy’s excess liquidity. Lending rates rise, making borrowing more expensive, stifling private investment. As a result, it prevents inflation.

Qualitative Tools   

  • Fixed Margin Requirement        
    • A higher margin requirement implies that more collateral is required for the same amount of loan. For example, if the margin requirement is 20%, a buyer will receive only Rs 80,000 as a loan for gold worth Rs. 1 lakh (if it is increased to 30 per cent, then a maximum loan of Rs. 70,000 can be given) As a result, in order to combat inflation, the RBI may impose higher margin requirements, raising the cost of credit availability. As a result of less loan disbursement and less private investment, there is less demand and thus less inflation.
  • Moral Suasion        
    • In the event of high inflation, the RBI may nudge banks to raise lending rates and implement a tight money policy.
  • Credit Control
    • RBI can direct banks to increase lending in one sector while decreasing lending in another.For example, if food inflation is rising, the RBI can direct banks to increase loans in agricultural sectors in order to bring prices down.
MONETARY POLICY